When AI Lies: The Booming Business of Insuring Artificial ‘Hallucinations’

An airline’s chatbot confidently invents a bereavement fare policy, costing the company real money in court. Lawyers submit a legal brief citing six entirely fictional cases, fabricated by ChatGPT, earning them a federal judge’s sanctions. A smart toy’s AI module glitches, forcing a costly and embarrassing product recall.

These aren’t hypothetical scenarios; they are the new, unsettling reality of doing business in the age of generative AI. The same powerful tools transforming industries are also prone to “hallucinations” – generating confident, plausible, yet utterly false information. When these digital ghosts in the machine cause financial, reputational, or legal harm, a critical question arises: Who pays the price?

For a long time, the answer was dangerously unclear. As businesses race to integrate AI, many are discovering that their traditional insurance policies are suddenly full of holes. Spooked by the unpredictable nature of AI failures, major carriers have begun adding specific exclusions, leaving companies liable for everything from an AI spreading libel to it infringing on copyright.

Into this void, a new and fascinating market is being born: AI liability insurance. Pioneering firms are now offering policies specifically designed to cover the fallout for when “AI goes wrong,” creating a financial backstop for a technology that is as brilliant as it is brittle.

The New Breed of Risk Takers

Leading the charge is Relm Insurance, a specialty carrier that in early 2025 launched a suite of products to tackle AI-specific risks. Their approach is a comprehensive toolkit for the modern enterprise. For the tech companies building the AI itself, their NOVAAI policy acts as supercharged professional liability coverage, protecting against claims of algorithmic bias or AI-generated defamation.

For the vast majority of businesses using AI, Relm offers two solutions. The PONTAAIpolicy is a “wrap” coverage, an ingenious safety net that fills the gaps in a company’s existing insurance. If an AI-powered diagnostic tool misreads a scan and the hospital’s malpractice and the vendor’s liability policies both deny the claim, this wrap policy is designed to kick in. The third policy, RESCAAI, covers a company’s own losses – like the income lost when a crucial AI system crashes during a Black Friday sale.

Meanwhile, in the historic halls of Lloyd’s of London, a different but equally innovative solution has emerged. Backed by syndicates like Chaucer, a policy developed by the startup Armilla directly targets AI “malfunctions,” including hallucinations and “model drift” – the slow degradation of an AI’s accuracy over time.

What makes the Lloyd’s product revolutionary is its performance-based trigger. Armilla first assesses the client’s AI model to establish a reliability baseline. The insurance only pays out if the model’s performance drops significantly below that benchmark, causing harm. It’s a clever way to quantify an abstract risk, essentially insuring against a verifiable breakdown rather than every minor error. It incentivizes businesses to use well-vetted, high-performing AI, turning the underwriting process into a form of risk management.

You Can’t Blame the Bot

This insurance boom is being fueled by a stark legal reality: you can’t sue the algorithm, but you can certainly sue the company that unleashed it. Courts and regulators are making it clear that using AI doesn’t absolve humans of responsibility.

If a chatbot produces libelous content, the company deploying it is seen as the publisher. If a generative AI tool copies protected artwork, the user who prompted it can be liable for copyright infringement. The dozens of lawsuits already filed against major AI developers by authors and artists are just the beginning. The law is treating AI not as an autonomous entity, but as a powerful, sophisticated tool. Just as you are responsible for how you operate a vehicle, a business is responsible for the outputs of its AI.

This is creating enormous potential liabilities. The European Union’s landmark AI Act, for instance, comes with fines of up to €30 million or 6% of global turnover for violations. This growing legal clarity is precisely why specialized AI insurance is shifting from a novelty to a necessity.

A Market on the Verge of Explosion

The parallels to the early days of cyber insurance are impossible to ignore. A niche product a decade and a half ago, cyber coverage is now a standard line item for any serious business. AI insurance is on the same trajectory, but moving at lightning speed.

Analysts at Deloitte project the global market for AI liability premiums could skyrocket to nearly $4.7 billion by 2032, growing at a staggering 80% annually. This growth is driven by pervasive AI adoption, a steady stream of headline-grabbing AI failures, and mounting regulatory pressure.

For businesses, this coverage offers more than just protection; it provides the peace of mind to innovate. Knowing that a catastrophic failure won’t lead to bankruptcy encourages companies to embrace AI’s transformative potential.

Of course, this new coverage will come at a cost. With little historical data on claims, underwriters are charging a premium for uncertainty. As the true frequency and severity of AI-related losses become clear, these premiums are expected to surge. Yet, for companies building their future on artificial intelligence, the cost of being uninsured may prove to be far greater. This emerging insurance market isn’t just a new product line; it’s the essential financial scaffolding that will allow the AI revolution to be built safely.

Read our full Report Disclaimer.